Global Outsourcing or Foreign Direct Investment: Why Apple Chose Outsourcing for the iPod

Global

outsourcing

or

foreign

direct

investment:

Why

apple

chose

outsourcing

for

the

iPod

Chu-Ping

Lo

*

DepartmentofAgriculturalEconomics,NationalTaiwanUniversity,Taipei,Taiwan

1. Introduction

Helpmanet al.(2004)arguedthatthemostproductivefirms preferforeigndirectinvestment(FDI)toarms-lengthtradewhen facedwithaproximity-concentrationtrade-off.Throughempirical studies,HeadandRies(2003)examinedthecaseofJapan,Girmaet al.(2005)examinedthecaseoftheUnitedKingdom,andWagner (2007)examinedthecaseofGermany,withallinargumentsthat themostproductivefirmspreferFDIoverexports.Thisassertion alsogainstheoreticalsupportfromAntra`sandHelpman (2004), whoappliedanincomplete contractmodeltodemonstratethat mostproductivefirmspreferFDIandless-productivefirmsprefer internationaloutsourcing.WhileHelpman et al.(2004)assume positivetransportationcostsandfirmsthereforefacethechoiceof whetherornottoexport,transportationcostsareassumedtobe absentintheAntra`s–Helpman’s(2004)model.Instead,Antra`sand Helpman (2004) apply an incomplete contract distortion to addressthedifferencebetweenFDIandinternationaloutsourcing strategies.Inall,bothapproachesassertthatthemostproductive firmsprefertoFDI.

However,someoftheworld’smostproductivefirms,especially intheelectronicsindustry(e.g.,Apple,Microsoft,Nokia, Hewlett-Packard)1 _{carry out international outsourcing intensively and}

operate almost no FDI activities in launching their innovative products (e.g., iPod, game consoles, cell phones and notebook computers,respectively).Forexample,inOctober2001,Applefirst marketedtheiPod,whichwasa‘‘disruptiveinnovation’’withasetof innovativefunctions(ClaytonandRaynor,2003).Beingthemost revolutionaryportablemediaplayerinhistory,andinthesixyears afteritslaunch,Applesoldover100millioniPodsworldwide(see Apple’s‘‘TheBestGoingOn’’conference).ThesuccessofiPodover competingmusicplayerscamefromradicalinnovationsinits user-friendlyinterfaceandsmoothintegrationwithMacandWindows throughwhichuserscouldeasilypurchaseanddownloadmusic/ videocontent.Appledesignedthemajorityofthesystem architec-ture of the iPod in-house but simultaneously outsourced the remaining four hundred-plus intermediate components to both domesticandinternationalcontractors.2_{Appleevencontractedout}

ARTICLE INFO Articlehistory: Received5June2010

Receivedinrevisedform22February2011 Accepted30June2011 JELclassification: F02 F14 Keywords: Electronicsindustry Internationaloutsourcing Incompletecontract FDI R&D ABSTRACT

Asimplemodelispresented,whereafirm’sproductivityisendogenizedbyitsR&Dinvestment.Itshows thatthemostproductivefirmsmaypreferinternationaloutsourcingtoforeigndirectinvestment(FDI)in industrieswithahighinnovationshare.Thehighinnovationsharemotivatesthefirmstoeconomizeon organizationalcostinordertosaveresourcesforR&Dinvestment,makingoutsourcingpreferabletoFDI becausetheformerincursasmaller organizationalcost.Thismodel helpsexplainwhyAppleInc., belongingto theelectronics industry,whichhasaparticularlyhighinnovationshare,launchedits innovativeiPodthroughinternationaloutsourcinginsteadofFDI.

ß2011ElsevierB.V.Allrightsreserved.

*Tel.:+886233662653. E-mailaddress:cplo@ntu.edu.tw.

1

BusinessWeekmagazineandtheBostonConsultingGroup’srankingof‘‘The World’sMostInnovativeCompanies’’in2006gaveAppleComputerInc.thetop rank,Microsoftthefifth,Nokiatheeighth,Sonythethirteenth,andHewlettPackard theforty-second.

2_{Afewhighcostcomponentsweremadebyothercompanies,suchasJapan’s}

Toshiba(harddriveforonboardstorage),Korea’sSamsung(flashmemoryfor temporary storage), and U.S.-basedBroadcom (integrated videoprocessor for mediaplayback)(Lindenet al.,2007).

ContentslistsavailableatScienceDirect

Japan

and

the

World

Economy

j ou rna l hom e pa ge : w w w. e l s e v i e r. co m/ l o ca t e / j we

0922-1425/$–seefrontmatterß2011ElsevierB.V.Allrightsreserved. doi:10.1016/j.japwor.2011.06.002

itscoresoftware;forexample,theuserinterfacewasdesignedwith the help of Pixo, and the reference platform was designed by PortalPlayer(Kahney,2006).Ofthe$299retailpriceforthe30GB videoiPod,Appleaccountedfora25percentshareofthevaluefor thecoresoftwaredesign,while36percentisattributedtocontracted manufacturersin the low-wageAsia-Pacific region that provide generic components and direct labor (Linden et al., 2007).3

Examplesofthegenericcomponentsanddirectlaborincludethe metal casing, provided by Taiwan’s Foxconn, and assembly, completedinChinesefactoriesownedbyTaiwanesefirmssuchas InventeeAppliancesandFoxconn(Einhorn,2007).Thepatternof globaloutsourcingalsooccurswithotherelectronicsproducts,such asHewlett-Packard’snotebookcomputers,with39percentofthe valueofanotebookcomputerattributabletogenericinputsand directlabor.

In contrast to the outsourcing literature (e.g., Antra`s and Helpman,2004;Antra`s,2005),whichhasarguedthatthemost productive firms prefer FDI to international outsourcing especially when the product is at the innovative stage, both AppleandHP haveworkedclosely withoutsidepartnersfrom thebeginningsofdesign. Thisapproachhasbeendramatically undertaken by the lead firms in the electronics industry (Sturgeon, 2002).

Whyistheninternationaloutsourcingprevailingforthelead firms(i.e.,mostproductivefirms)intheelectronicsindustries? Theliteratureofglobalvaluechainprovidesanexplanation:itis the advances in information technology (IT) enabling the electronicsindustry to more easily standardize the interfaces betweencomponents,suchthatthecomponentmodularization hasmadeinternationaloutsourcingmoreattractivebyallowing multiplefirmstosharethesamegenericcomponentsatalower cost due to economies of scale (Sturgeon and Lee, 2001; Sturgeon, 2002).4 _{However, a shortcoming of the product}

modularization hypothesis is that the lead firms in the electronicsindustry(e.g.,ApplecomputerandHewlett-Packard) have contracted out not only generic but also non-generic components.

Another key factor facilitating the growth of international outsourcing in the product modularization hypothesis is the lead firms’ desire to reduce fixed organization investment, especiallyinmanufacturingfacilities(SturgeonandLee,2001).I borrowthisconceptinthispaper,andarguethattheprevailing dependenceonglobaloutsourcingintheelectronicsindustryis largelyduetoNorthern firms’leveraging themassproduction capacity of those in the South. For example, Flextronics,5 _a

contractelectronicsmakerheadquarteredinSingapore,worked withMicrosoftintheinitialstageofdeveloping itsinnovative game console, Xbox, by building customized (as opposed to generic)mechanical parts andperforming system tests. More importantly was Flextronics’ capacity to ramp up production fromzeroto100,000consolesperweekinlessthanfiveweeks. Production capacity was important because ‘‘if the system [Xbox] could not be built cost effectively and ramp up in volumes, it would have little chance against the more establishedsystemsonthemarket’’(Carbone,2002).Therefore, theinnovativeMicrosoftfocusedonR&D activitiesin orderto develop a game system that was technologically superior to rivalsystems(e.g.,Sony’sPlayStation),andthenoutsourcedthe

low-techcomponentstothesecontractfirmsthatspecializedin massproduction,therebyavoidingthesubstantial organization-al costs of establishing a production capacityabroad through FDI.6_{Withthesespecializedcontractmanufacturersaroundthe}

world, theworld’s mostproductive andinnovativefirms, well known for their R&D capabilities, may prefer international outsourcingtoFDI as a waytocut costs andimprovegeneral productivitywhenlaunchingtheirinnovativeproductsbecause FDI incurs a larger fixed organization cost than international outsourcing.

The purpose ofthis studyis todetermine why the world’s mostproductiveandinnovativefirmsmaypreferinternational outsourcing to FDI.I incorporate Griliches’ (1986) production function into Antra`s–Helpman’s(2004) modelto argue thata Northern firm determines its global organizational structure basednot only ona trade-offbetween low-waged production costsandincompletecontractdistortion,butalsoonatrade-off between R&Dinvestment andorganizational cost.Iarguethat an increase in the innovation share augments the trade-off between R&D investment andorganizational cost, whichmay takeprecedentoverthetrade-offbetweenproductioncostsand incomplete-contract distortion when the innovation share is sufficientlylarge.Asithappens,inindustrieswithasufficiently high innovation share, the most productive firms tend to carry out international outsourcing activities rather than FDI becausethehighinnovation shareenhances theadvantagesof R&D investment. On the other hand, in industries with a relatively low innovation share, the most productive firms prefer FDI tooutsourcing becauseoutsourcing incurs a larger incomplete-contractdistortion.

Theremainderofthispaperisorganizedasfollows.InSection2, I revisit Griliches’ (1986) results by applying data from the Industrial R&D Investment Scoreboard reported by Eurostat to determinehowtheinnovationsharevariesacrossindustries.In Section3,Iadd toAntra`s–Helpman’s(2004)modelofGriliches’ (1986) production function, in which firms’ productivity is augmentedbyinnovation,andIarguethatthisdifferenceinthe innovationsharereshapesafirm’sglobalorganizationalform.In particular, the ordering in Antra`s–Helpman’s (2004) model is reversedwhenanindustryhasasufficienthighinnovationshares. Section4concludes.

2. R&Dinvestmentandproductivity

Itis welldocumentedthat researchand development hasa positive effect on productivity (e.g., Leonard, 1971; Mansfield, 1980; Griliches, 1980, 1986; Lichtenberg and Siegel, 1991; Meddaet al.,2003).7Theoretically,Griliches(1986) definedan augmentedCobb Douglasproductionfunction withaninput of R&DinvestmentandillustratedthatR&Dcontributesto produc-tivitygrowthinU.S.manufacturing.8_{ByusingtheNationalScience}

Foundationdatasetonabout1000ofthelargestU.S. manufactur-ingfirmsfrom1957through1977,Griliches(1986)foundthatthe innovation share,measured by thecontributionof theR&D on

3

Distributionandretailsaccountedforanother25percent.InputsfromJapan accounted9percent,whileinputsfromTaiwanaccountedfor1percent.

4_{Nevertheless, theproductmodularizationisalso underwayinmanyother}

sectors as well, such as apparel and footwear, toys,food processing, home furnishingsandlighting,brewing,andautomotiveparts,pharmaceutical produc-tion,butnotonlybeendramaticintheelectronicsindustry(Sturgeon,2002).

5

Foxconn also manufactures iPods for Apple, cell phones for Nokia, and computersforHewlettPackard,amongothers.

6_{InresponsetoMicrosoft’sgeneralproductioncostsavingfromoutsourcing,}

SonyoutsourceditsPlayStationgameconsoletoFoxconn,aTaiwanesefirmwhose majorproductionfacilitiesarelocatedinChina.

7

Empirically,Griliches(1980)hasrevealedapositiveandrobustrelationship betweenR&DandtotalfactorproductivityfortheUnitedStates,asdidMeddaetal. (2003)forItaly.

8

TheproductionfunctioninGriliches’(1986)modelisgivenbyY=AIr

L1b

Cb(see alsoLichtenbergandSiegel,1991),whereLdenoteslaborandCdenotescapital. Here,Adenotesneutraltechnologystockthatisaccessibletoallproducers.R&D inputI=PisiKtiis a measure of thedistributed lageffect of past research

investmentsonproductivity,whereKtimeasurestherealgrossinvestmentin

researchinperiodi,andsiconnectsthelevelsofpastresearchtothecurrentstateof

productivity,ranges from0.09 to 0.17.9 _{In revisiting Griliches’}

results, I use a more recent dataset from the Industrial R&D InvestmentScoreboardreportedbyEurostat,whichcollecteddata from more than 1,000 of the largest firms’ audited financial accountsandannualreportsfrom2002through2005.Thesefirms werepubliclylistedcompanieswithregisteredheadofficeslocated within the OECD member countries. However, the Scoreboard designatescompaniesinaccordancewiththeir sector classifica-tion,asdefinedbytheFinancialTimesStockExchangeIndex(ICB Classification).

AsshowninTable1,mycross-sectionalestimatedinnovation shareonOECDfirmsforallindustriesin2002–2005isabout0.12, whichissimilartoGriliches’sestimationthatofU.S.firmsin1966– 1977.10_{Furtherexaminationofindustry-specificinnovationshare}

findsvariationamongindustries.Table1reportstheestimationof the innovation share for each industry, based on the ICB Classification codes for various industries. Industries with less than30observationsarenotpresented.AsshowninTable1,the estimated innovation share varies substantially among these industrygroups.Forexample,thecomputerhardwareindustryhas thehighestinnovationshareat0.46,andtheautomobilesandparts industryhasthelowestat0.05.Becauseofthevariationamong industries,Idividetheseindustriesintothreegroups:industries withanestimatedinnovationsharelargerthan0.30are catego-rizedas‘‘IndustrieswithHighInnovationShare’’;thosewithan estimated innovation share less than 0.15 are categorized as ‘‘Industries with Low Innovation Share’’; and the remaining industriesarecategorizedas‘‘IndustrieswithMediumInnovation Share.’’

Mostindustries have a low innovation share of somewhere around0.1 and belongto the‘‘Industries with LowInnovation

Share’’ group.Five industries have exceedingly large estimated innovation shares, ranging from0.30 to 0.46(0.4 on average). Amongthesefiveindustries,threehavethesamethree-digitICB code(957),andallhavethesametwo-digitICBcode(95).Inother words,thefiveindustriesbelongingtothe‘‘IndustrieswithHigh InnovationShare’’groupareallelectronicsandITindustries. 3. Themodel

TheseminalmodelofAntra`sandHelpman(2004)andAntra`s (2005)providethebasicstructureformyanalysis,wherelaborisa unique factor of production. Assume that, in the North-South world, there are J+1 industries, where J industries produce a continuumofdifferentiatedproducts,andtheremainingindustry producesahomogeneousgood.Thehomogeneousgoodisusedas a numeraire that can be freely produced and traded in both countriesinequilibrium.Consumershavesimilarpreferencesover alldifferentiated goods,andeach consumermaximizesa utility function: U¼x0þ 1 u XJ j¼1 Xu j; 0<u<1; (1)

wherex0representstheconsumptionofthehomogeneousgood,Xj isanindexofaggregateconsumptionofthedifferentiatedproducts in industry j, and u is a parameterrepresenting thedegree of substitution acrossdifferentiated-productindustries.The aggre-gate consumption in industry j, inturn,is a constant elasticity substitution(CES)utilityfunctionoftheconsumptionofdifferent varietiesoffinalgoodsxj(i):

Xj¼

Z

xjðiÞadi

 1=a

; 0<

a

<1; (2)

wheretherangeofvarietyiisendogenouslydetermined.Assume that

a

>u so that varieties are more substitutable within an industrythanacrossindustries.Thisleadstoaninversedemand functionforeachfinalgoodias

pjðiÞ¼Xuj axjðiÞa1; (3)

wherepj(i)isthepriceofthefinalgoodxj(i).

Table1

Cross-sectionalproductions:allindustries.Dependentvariable:lognetincomeofOECDfirms:2005.

Industries E.coefficient No.ofobservation R2

Allindustries 0.12(0.01) 1557 0.93

Industrieswithhighinnovationshareðˆr0:3Þ

Computerhardware(ICB9572) 0.46(0.08) 55 0.95

Software(ICB9537) 0.45(0.07) 122 0.86

Semiconductors(ICB9576) 0.43(0.05) 91 0.91

Telecommunicationequipment(ICB9578) 0.35(0.06) 61 0.94

Electroniccomponents(ICB2733) 0.30(0.07) 48 0.94

Industrieswithmediuminnovationshareð0:3> ˆr>0:15Þ

Householdgoods(ICB372) 0.27(0.07) 26 0.97

Healthcare(ICB453) 0.23(0.05) 76 0.97

Industrialmachinery(ICB2757) 0.16(0.04) 87 0.94

Industrieswithlowinnovationshareðˆr0:15Þ

Aerospaceanddefense(ICB271) 0.13(0.06) 40 0.98

Pharmaceuticals(ICB4577) 0.13(0.06) 85 0.91

Foodproducers(ICB357) 0.10(0.07) 39 0.91

Constructionandmaterials(ICB235) 0.08(0.05) 48 0.95

Chemicals(ICB135) 0.07(0.05) 109 0.90

Automobileandparts(ICB335) 0.05(0.05) 71 0.97

Netsalesexcludesalesofjointventuresandassociates.FollowingGriliches(1986),R&DstockistheaccumulatedsumofR&Dexpendituresfrom2002through2005basedon anassumptionof15percentdecliningbalancedepreciationperyear,wheretheR&Dexpenditureiscashinvestmentsfundedbycompaniesthemselves.Standarderrorsare showninparentheses.

Industrieswithfewerthan30samplefirmsarenotshown.Standarderrorsareshowninparentheses.Thethreeindustrygroupsarebasedontheirestimatedinnovation shareðˆrÞ.

9

PleasealsoseeEq. (4)foraclearerdefinitionoftheinnovationshare.To eliminatefixedeffects, Griliches(1986)analyzedthegrowth rateofadjusted productivityonthegrowthrateofR&Dinvestment,resultinginanestimationof 0.12,whichisveryclosetohisestimationinthecross-sectionallevelregression.

10_{Thebiotechnologyindustryisnotoriousforitsfledglingmarketsinwhichmany}

firmshaveeithernegativenetincomesorenormouslylargeR&Dspending,soIrun tworegressions,onethatincludesthebiotechnologyindustryandanotherthat doesnot.Bothregressionshavealmostthesameresults.Incomparisontoother industries,onlythebiotechnologyindustryhasanegativeestimatedelasticity; however,itssmallsizedoesnotaffectourestimation.

In Antra`s–Helpman’s (2004) model, the unique final good producerofvarietyidrawsaparticularrealization

u

fromaknown distribution.11 _{Instead, in this current model, I argue that the}

productivityisendogenouslydeterminedbyafirm’Researchand Development(R&D)decisionas:

u

¼AINðiÞrj; (4)

where IN(i) denotes R&D investment made by the final good produceriintheNorthandAisanexogenousparameterdenoting theneutralproductivity.In(4),rjisanindustry-specificparameter denoting the extent to which skilled workers are efficiently employed, and 0<rj<1.12 It will be shown clearly in a later discussionthatrjincreasesanindustry’sR&Dintensity.Afirm’s productivityincreasesastheinvestmentinR&Dincreases,butin diminishingreturns.Obviously,incomparisontoindustrieswitha lower innovation share, a firm in an industry with a high innovationshare,ceteris paribus,is encouragedtoallocatemore resourcestoR&Dinvestmentawayfromorganizationinvestment inordertoraiseproductivityandrevenue.

Thefirmiinanindustryjisheterogeneousinproductivityand thenincorporates high-andlow-techinputsofHj(i) andMj(i) in production of the final good xj(i). The firm manufactures the high-tech inputsbutrelocatesthelow-techinputstotheSouthbyeitherFDIor internationaloutsourcing.Theproductionfunctionisthengivenby: xjðiÞ¼

u

HjðiÞ 1zj  1zj _M jðiÞ zj  zj ; 0<zj<1: (5)

Thevariablezjrepresentsthematurityoftheindustryj,witha largerzimplyingthattheindustryisatamorematurestage.Let the wages of the North and South be denoted as wN and wS, respectively, and let wN>wS. Incorporating (4) into (5), the productionfunctionisrewrittenas

xj¼AINrj Hj 1zj  1zj _M j zj  zj : (6)

Becoming a Griliches-type (1986) production function, (6) presentsanincreasing-return-to-scalecharacteristic.For simplic-ity,theindustryindexjisdroppedfromallofthevariablesinthe followingdiscussion.

3.1. Divisionofsurplusandorganizationcosts

Tofocusonoffshoreproduction,Ionlydiscussthecaseswhere thelow-techinputsareproducedeitherbyFDIorbyinternational outsourcing.Asiswellknown,offshoreproductionislimitedby the incomplete nature of contracts governing international transactions.Duetothenon-verifiabilityoftherelevantstateof theworld,thepresenceofincompletecontractsleadstheparties involvedin offshoreproduction toacquire partialreturns,such that they may under-invest ex ante in relationship-specific investments. The threat of underinvestment motivates the Northern firm to purchase more residual rights from the subsidiarieslocatedintheSouthbyverticalintegration(FDI)in order to reduce the impact of potential underinvestment in comparingtointernationaloutsourcing.13

Therefore,atrade-offassociatedwiththeallocationofownership rightsarisesbetweenorganizationcostsandincomplete-contract

distortions. After a goodquality prototypeis provided, the two parties bargain over the surplus from the relationship-specific partnership.Ifsuchbargainingresultsinanagreementbetweenthe parties,from(3)and(5),thenthepotentialrevenuefromthesaleof thefinalgoodis:

RðiÞ¼Xua

u

a HðiÞ 1z  að1zÞ MðiÞ z  az : (7)

However,ifthepartiesfailtoagree,theoutsideoptionofthe low-techinputsproducerwillbezerowhilethatofthehigh-techinputs firmswillvarywithdifferentorganizationalstrategies.Following Antra`sandHelpman(2004)andAntra`s(2005),theexpostsurplus shareisdependentonafirm’sorganizationalstructureas

b

K2(0,1), whereK2{V,O},whereVdenotesFDI,andOdenotesinternational outsourcing.Thatis,theNorthernfinal-goodproduceracquiresa fractionoftheexpostsurplus(i.e.,

b

R(i))whiletheremainingsurplus isattributedtothelow-techinputprovider(i.e.,(1

b

)R(i)).Antra`s andHelpman(2004)alsoassumedthatanFDIfirmacquiresmore leverage than one that outsources, resulting in the order of

b

V>

b

O>1/2.14Notethatof the$299retailprice forthe30GB iPod,36percentofthevalueisattributedtogenericinputsanddirect labor provided in large part by firms in the Asia-Pacific region (Lindenet al.,2007).Similarly,fora$1400HPnotebookcomputer, about39percentofvalueisattributedtogenericinputsanddirect labor. Thus, atleast in the electronics industry, it is feasible to assumethatthe

b

Oisaroundone-halftotwo-thirds.

Antra`sandHelpman(2004)alsoassumedthatFDIincurslarger fixedorganizationalcosts(investment),suchasfV>fO,wherefV and fO denote the fixed organizational costs for FDI and international outsourcing, respectively. In this paper,I use the sameorderingofdivisionofsurplusandorganizationcosts. 3.2. Equilibrium

Supposetherearenumerouslow-techinputsuppliersbidding forthelow-techinputcontractbypayingttotheNorthernfirms, wheretcanbeeitherpositiveornegative.Theincometransferwill cancel outin thejoint profitmaximization, so, forsimplicity, I neglectitinthefollowingdiscussion.AsinAntra`sandHelpman (2004)model,IassumeunitproductivityformanufacturingtheH andMinputsineithercountry.However,inthiscurrentmodel,the productivity is endogenously determined by a firm’s R&D investment,whichiscarriedoutbytheNorthworkers.

Withthe aboveset-up, a finalgood producermaximizes its profit:

max

IN;H

bK

RwNINwNHwNfK; (8)

wherethefirm indexiisdroppedforsimplicity.Thefirst-order condition of (8) associated with the choices of H leads to

ab

K(1z)R=wNH,while that associated withthechoices ofIN leadsto

a

r

b

KR=wNIN.Theequilibriumshowsthatindustrieswith ahigherinnovationshare(i.e.,r)tendtohavehigherR&Dintensity (definedaswNIN/R=

a

r

b

K).Further,thelow-techinputsproducer maximizesitsprofitas

max

M ð1

bK

ÞRwSM: (9)

Thefirst-orderconditionof(9)associatedwiththechoicesofM isgivenby

a

ð1

bK

ÞzR¼wSM:

11

AParetodistributionasinHelpmanet al.(2004).

12

Jones(1999)referredittoasthe‘‘steppingontoes’’effect(i.e.,thatduplication ofR&Deffortsismorelikelywhentherearetoomanypersonsengagedinit).The duplicationofactivitiesreducestheefficientuseofR&Dresources.

13

GrossmanandHart(1986)arguedthatcontractualrightsconsistofspecific rightsandresidualrights.Sinceitwouldbetoocostlytolistallthespecificrights overassetsinthecontract,soforeigninvestorsmightfinditadvantageousto purchasetheresidualrighttohavefullcontrolovertheasset.

14

GrossmanandHelpman(2005)assumed that,inthecaseofinternational outsourcing,Nashbargainingmakesthepartiesshareequallyinthesurplusthat accruesfromtheoutsourcingcontracts,thatis,bS=1/2.

Combining(8)and(9),theprofitoftheheadquartersfirmunder jointprofitmaximizationisthengivenby

pK

ðr;X;zÞ¼Xua

u

aHað1zÞ_Maz

wNINwNHwSM

wNfK: (10)

Incorporating theabove first-order conditions into (10), we obtain

p

C K¼Xma=ð1aÞ

u

a =ð1aÞ

c

CKwNfKC; (11) where

c

Kð

b

KÞ¼ð1

a

r

b

K

a

½

b

Kð1zÞþzð1

b

KÞÞ=½ð1=

a

ÞðwN=

bK

Þ1zðwS=1

bK

Þza=1a (seeAppendix Aforthederivation).In

(11),theprofitmaximizationisequivalenttothemaximizationofits slope,

c

K.Theoptimaldivisionofsharecanthenbederivedbytaking

˙

cK

ð

bK

Þ¼0;in particular,we obtain

b

¼ðð1zþr=2Þð1

a

zÞ ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi ½ð1zþr=2Þð1

a

zÞ2ð12zþrÞð1

a

zÞð1zÞ q Þ=ð12zþrÞ, which converges to the original Antra`s and Helpman (2004) expressionwhenr=0.

As shown in Table 1, the majority of industries have an innovationshare of aroundr=0.1, but theelectronics industry groupalonehasahighinnovationshareofaboutr=0.4.Wecan plot

b

*(z)asafunctionofzforanindustryj,whichhasaspecificrj, bysimulationasshowninFig.1.

Tosharpenthecontrast,Iintroduceonlytwodifferentindustry groupsinthesimulation:onewithahighinnovationshareof0.4 andtheotherwithalowinnovationshareof0.1.Thethincurvein Fig. 1 illustrates the case where r=0.1, and the curve in bold illustratesthecaseinwhichr=0.4.Specifically,the

b

*(z,r=0.4)in Fig.1denotestheelectronicsindustryand

b

*(z,r=0.1)represents theotherindustries.Itiseasytofindout

b

*(0,r)=1/(1+r)and

b

*(1,r)=0,suggestingthattheoptimal

b

*fortheskill-intensive industryislowerifthecorrespondinginnovationsharerisgreater. Forcomparison,Ialsoillustratethedivisionofsurplusdetermined bybargainunderFDIandunderoutsourcingmodesinFig.1. 4. FDIvs.outsourcing

Outsourcing strategy dominates FDI in the labor-intensive industries (i.e., z>0.5), as illustrated in Antra`s and Helpman (2004)model.Thus, inthis paper,Ifocus ontheskill-intensive industries(i.e.,z<0.5),inwhichourresultsdiffer.Tofocusonour analysis,Ialsoassumeinthismodelthatthewagegapbetweenthe North and the South is large enough so that the strategy of domestic production is preferred by all other organizational structures.

Inanindustrywithalowinnovationshare(asmallerr),

b

Vis closertotheoptimal

b

*curvethan

b

O,indicating

c

V>

c

O.Then, wecanplottheprofitwithrespecttotheproductivity

u

ai=1afor

thelowinnovationshareindustriesasinFig.2.Asimpliedin(11), the slopes of the profit lines are crucially determined by

c

K, indicatingthattheFDImodeisamoreoptimalstrategythanthe outsourcingmodeforthemostproductivefirms.Thisresultisin linewithAntra`s–Helpman’s(2004)model.

This current model deviates from Antra`s–Helpman’s (2004) modelwhentheinnovationshareissufficientlylarge.Fig.1shows that,thehighertheinnovationshareinanindustry,thecloserthe outsourcingmodeistotheoptimaldivisionofsurplus.Thatis,in anindustrywithahighinnovationshare(alargerr),

b

Oiscloserto theoptimal

b

* curvethan

b

V,indicating

c

V<

c

O.Asshown in Fig.3,theslopeoftheprofitlineunderFDImodemaybesmaller than that of outsourcing mode, implying that the outsourcing

Fig.2.Equilibriuminindustrieswithalowerr. Fig.1.Distributionofb*ofelectronicsandtheotherindustries.

modemaybeamoreoptimalstrategythantheFDImodeandmore profitable.Asaresult,themostproductivefirmsinanindustry with a higher innovation share may prefer international out-sourcing to FDI. This is particularly true for the electronics industry,whichhasanespeciallylargeestimatedinnovationshare compared to that of other industries. I argue that the high innovation share motivates Northern firms to economize on organizational spending in order to save resources for R&D investment,therebymakingthefirmmoreproductive.Thus,the internationaloutsourcingmodeispreferredbecauseitrequiresa lowerorganizationalcostthanFDI.

As is well known, the opportunistic underinvestment may takeplacewhencontractsareincomplete(GrossmanandHart, 1986; Hart and Moore, 1988). The division of surplus

b

K is bargainedoverseekingtobalancethe underinvestmentofthe final-goodproducerandintermediate-inputsuppliers.Notethat eachparty’sseverityofunderinvestmentisinverselyrelatedto thefractionofthesurplusthatitappropriates. Iarguethatan increasein R&D investment, whichincreases productivityand revenuemoreinanindustrywithahighinnovationsharethan inanindustrywithalowone,enlargestheopportunitycostof underinvestmentfor both parties. As a result, the severity of underinvestmentis scaleddownwhentheinnovationshareof an industry is high. With less severity in opportunistic incentives, the profit-maximizing final good firms may adopt a structure of international outsourcing rather than FDI to economizeonorganizationalcosts.

ThisargumentissomehowinlinewiththatofGlassandSaggi (2001), who presented a product cycle model to argue that shifting production to the South increases product market profits throughthe lower wagecost of production there,and frees up Northern resources for innovation. However, our approachinthispaperdiffersfromthatoftheirmodelinmany respects.Theirmodelisdrivenbydifferencesintechnologyand wageratesbetweentheNorthandSouth,whereasourmodelis driven by the differences in incomplete contracts and in organizationcosts betweenFDI and internationaloutsourcing. Theirmodelonlyaddressestheproblemofoffshoreproduction (international outsourcing only) or not while our analysis addressestheproblemofwhichmethodofoffshoreproduction (i.e., FDI or international outsourcing) may play a more important role in freeing up the resources of Northern firms inimprovingproductivity.

5. Conclusions

Thedifferenceininnovationshareamongindustriesimpacts thefirms’globalorganizationalform.Inanindustrywithahigh innovation share, the Northern firm tends to economize on organizationalinvestmentinordertoputmoreeffortsintoR&D investmentwhileR&Dinvestmentandorganizationalcostsare substitutive. That is, the firms in an industry with a larger innovation shareare encouraged todevote more resourcesto R&Dinvestment,ceterisparibus,inordertoincreaseproductivity andenlargerevenuebutwhilesimultaneouslychoosingalower cost of global organizational from in order to minimize the aggregate nonproduction costs. While an increase in revenue (duetoanincreaseinR&Dinvestment)enlargesanopportunity costofunderinvestmentforthetwopartiesinvolved,themost productive firms in those industries with a larger innovation sharetendtopreferinternationaloutsourcingtoFDIwhilethe incompletecontract distortion is restrained.This model helps explainwhytheworld’smostproductivefirms,suchasApple, Nokia, Microsoft, and HP (all in the electronics industry), often prefer international outsourcing to FDI when launching innovativeproducts.

Acknowledgment

ThefinancialsupportprovidedbytheNationalScienceCouncil (NSC96-2415-H-002-019)isgratefullyacknowledged.

AppendixA

From(8),we haveH¼ð

abK

ð1zÞ=wNÞRandIN¼ð

a

r

bK

=wNÞR.

From(9),wehaveM¼ð

a

ð1

bK

Þz=wSÞR.PlugtheoptimalHandM

into(7),weobtain R¼Xua

_u

a

abK

wN R  að1zÞ

a

ð1

bK

Þ wN R  az : (A1)

Wecanrearrange(A1)as R¼Xua=1a

_u

a=1a

abK

wN  að1zÞ=ð1aÞ

a

ð1

bK

Þ wN  az=ð1aÞ : (A2)

Thejointprofitmaximizationin(10)isthengivenby

pK

ðr;X;zÞ¼Xua

u

aHað1zÞMazwNINwNHwSM wNfK ¼R

a

r

bK

R

abK

ð1zÞR

a

ð1

bK

ÞzR wNfK ¼f1

a

r

bK



a

½

bK

ð1zÞþð1

bK

ÞzgR wNfK: (A3)

Plug(A2)into(A3),weobtain

pK

¼Xma=ð1aÞ

_u

a=ð1aÞ

cK

wNfK; (A4) where

c

Kð

b

KÞ¼ 1

a

r

bK



a

½

bK

ð1zÞþzð1

bK

Þ ð1=

a

ÞðwN=

bK

Þ1zðwS=1

bK

Þ z h ia=ð1aÞ

The optimal division of share can then be derived by taking ˙

cK

ð

bK

Þ¼0; It is equivalent to take derivative of f1

a

r

bK



a

½

bK

ð1zÞþzð1

bK

Þg½ð

bK

Þzð1

bK

Þ1za=ð1aÞwithrespectto

b

K. Itistheneasytocalculatetheoptimaldivisionofshare

b

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